The Bottom Line : 'Fed, up'

WASHINGTON, May 14 (UPI) -- Central bankers around the world, like old generals, have a reputation for fighting obsolete wars. It is no less so in 2004, as the U.S. Federal Reserve looks for a way to exit from a low-rate posture it has maintained throughout the last six months, designed to combat a recession that ended more than a year ago.

The opportunity for investors is to profit from the short-term uncertainty as the Fed hints and postures and waffles when, perhaps, it should simply raise rates and start fighting the current and coming war. The drums of that war, inflation, are already audible in the form of rising commodity prices, a steep yield curve, and rising rates on the market -- which the Fed now lags badly.

A month ago, with the Nasdaq and the Dow each 5 percent above current levels, "Bottom Line" wrote:

"It's probably the right time to take profits and reduce positions in those countries that have enjoyed a recent rally....We're also short a number of overbought developed-country markets that will suffer disproportinately from internal weakness and global violence in the coming weaks.

"That pain and those attacks are likely to be felt especially by that mother of all democracies, the first emerging market itself, the United States.... Sometimes, the best place to have your money is in cash."

("Short on global longs," the Bottom Line, April 9.)

Part of our thinking had to do with the nature of Fed Chairman Alan Greenspan, whose economic policy-making must have been the inspiration for the phrase, "baby steps." Greenspan's rap sheet as a serial over-incrementalist date back to his days as an economic advisor to Gerald Ford, where he helped promote the "Whip Inflation Now" button, to the unambitious Social Security reform he authored in the early 1980s.

The Greenspan Fed, meanwhile, also authored the too-slow easings of 1991-1993 and 2001-2003, and the too-late too-slow tightenings of 1988-1990, 1994-95, and, now, 2004-2005. Like Romeo and Juliet, Greenspan's Fed no less than other central banks always seems to arrive just after someone else has swallowed poison.

Paul Ryan, a bright young congressman from Southern Wisconsin, put it well when he asked Greenspan recently: "Isn't it possible that a small adjustment now would make it unnceccesary to have larger, more painful adjustment later?" Greenspan's reassurance that there appears to be no major inflation threat at present was not reassuring. The inflation threat is in the future, due to policies in place now. The signs, meanwhile, are arguably not balanced, but on the inflation side.

Most recent analysis of the stock market's woes suggest that investors are afraid that the Fed is about to start raising interest rates, and hence, bidding down stocks. "Bottom line" has argued for some time that the opposite is the case -- investors are afraid the Fed will be timid about beginning to raise rates now, or, to be more precise, they are afraid of a grudging, indecisive, series of too-late too-timid steps.

Every recent signal of strong growth, and surging producer prices -- yes, we include "the volatile food and energy sector," since most producers have to heat or air condition factories and homes, drive cars, transport goods, and pay employees who eat food -- reinforces the market's belief that it's now time to end absurdly low short-term rates of 1 percent. (That's a negative interest rate in real terms.) When the Fed reacts to the admittedly small, but growing, fire by promising to pour cups of water on it, and only at a later date with extreme caution -- investors are, far from being reassured, more scared than ever.

Consider:

1. Every serious inevestor has known for the last year that rates were at their bottom. And in the last three months, market rates have risen virtually 100 basis points (1 full percentage point) on the short end. The market concluded in January and February that rates would have to rise, and stocks did fine. It is only in recent weeks -- as the Fed seems not to hear the inflation war drums so audible to everyone else -- that U.S. equities have faltered.

2. Recent Fed statements to reassure the markets, and give ample warning of the coming tightening, seem to have the opposite of the intended impact. Greenspan and the governors, it is said, fear this is 1994 -- when Fed rate increases supposedly shocked the markets. The fact is, however, the Fed, as The Economist noted recently, gave ample warning of a tightening through most of 1993. Perhaps this is 1994 all over again: But once again, investors are concerned mainly that the Fed seems too slow to recognize reality, and too timid to take action now against threats that, by their nature, will not be mature until it is too late to preempt them.

For all his flaws, Greenspan the mensch is a thoughtful guy who is liked and -- more important -- respected by Wall Street. This may be another reason for the state of heightened concern for U.S. stocks.

The market knows that this tightening will start under Greenspan, but most likely be carried on and end under another. As the "Bottom Line" predicted more than six months ago, Greenspan's recent willingness to speak more frankly about deficits, taxes, Social Security, and other matters is a sign that he plans to end his term as Fed chairman sooner rather than later -- perhaps early in 2005.

A second-best way to soothe the markets would be for Treasury Secretary John Snow to offer support for the coming Fed rate hikes -- a friendly but implicit spur to Greenspan to get moving. Snow has done much good already this year in encouraging a Chinese tightening and rising won, and promoting (though so far without success) an easing by the European Central Bank.

The first-best response, in policy terms, would be a 0.25 rate increase now, today; with an indication that another 0.25 to 0.5 is likely to follow by the end of June. Action trumps rhetoric, and will actually allway market fears.

Neither action from Greenspan nor leadership from Snow on U.S. rates is likely, though, which is why "Bottom Line" recommends holding on to some of those shorts on the U.S. market that you bought in March and April -- and keeping a nice buffer of 30 percent or more in cash as well. The time to cover, and go long, will be when the rate hikes start and the markets sigh relief. Short for now.

Gregory Fossedal manages international investements for Emerging Markets Group in Washington, DC. His clients may (and usually do) hold long and short positions in many of the investment securities and opportunities mentioned in his reports. "The Bottom Line" is compiled from sources we believe to be reliable, but no representation is made that they are necessarily accurate or complete. Investors should perform their own due diligence and consult their own professional advisor before buying or selling any securities. Mr. Fossedal's opinions are entirely his own, and are not necessarily those of UPI or EMG. Futhermore, they are subject to change without notice. Email: foss@dcfund.net.

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